An annuity is a close financial cousin to a life insurance contract and pays periodic income benefits for a specific period of time or over the course of a lifetime. Life insurance companies offer annuities. There are two basic types of annuities: deferred and immediate. Deferred annuities allow assets to grow over time before being converted to income payments. Immediate annuities begin payments immediately, or within a year of purchase.
The act of converting a deferred annuity to income is known as annuitization. The value of funds being converted to income is known as the annuitization value. In sum, a deferred annuity allows the covered person to accumulate funds for retirement and then receive a guaranteed income payable for a specified period or for life.
An annuity may be fixed or variable. The U.S. Securities and Exchange Commission typically does not regulate fixed annuities, but it does regulate variable annuities. In a fixed annuity, all assets underlying the annuity are held in the insurer's general account with the insurer bearing the investment risk. In a variable annuity, the insurer will hold all the assets underlying the annuity in a separate account and the annuity owner bears the investment risk, directly participating in the gains and losses of those assets, net of any fees. These separate account assets are composed of assets in specified variable annuities which are invested in specified investment subaccounts provided within the annuities. These investment subaccounts are not publicly traded.
In entering an annuity contract, the annuity owner pays a premium in return for guaranteed income payments. Many deferred annuities allow annuity owners to deposit additional money, possibly restricted to periods of time or to maximums or minimums. In return, the annuity owner is entitled to receive an income stream in the form of periodic payments after a certain holding period, which is known in the art as the accumulation phase or period. Typically the annuity owner can choose when to annuitize and begin receiving income payments from the insurer. The period over which income is received is known as the payout or income phase or period.
Outside of an annuity, an individual can attempt to self-fund their retirement income by making regular withdrawals from their asset portfolio. Self-funding allows the individual to retain control and ownership over their assets instead of exchanging them for an annuity contract which could guarantee income payments for life. With self-funding, however, there is no guarantee that those withdrawals can continue for their lifetime without depleting the asset portfolio. Investment return performance shortfall and/or volatility as well as longevity of life are two risks which could significantly impact the ability of the asset portfolio to support these withdrawals for the individual's entire lifetime.
A guaranteed minimum accumulation benefit (GMAB) is a benefit which can be associated with an annuity which guarantees a minimum accumulation value after the accumulation period or a set period of time. This guaranteed value could be based on the amount invested or on prior gains. This guarantee protects the value of the annuity and the annuitant from market fluctuations. This benefit may be optional to an annuity for an added cost, which varies by each annuity contract or issuing firm. The GMAB will be “in-the-money” only if the market value of the annuity is below the minimum guaranteed value.